Investing in Asia Pac & European Stocks
TWST: Please start with an overview of the Mutual International Fund (FMIAX), including a portfolio snapshot and the fund’s strategy.
Mr. Sleeman: Like our other Mutual Series Funds, we’re value investors. We look to buy equities at a discount to their intrinsic value, and think a lot about margin of safety and downside protection. By intrinsic value, we think about what might be the price that an industrial player would pay for the business, and by margin of safety, we look at what sort of stress is implied in the price and what happens if we reasonably stress the business. We can also invest in distressed debt and merger arbitrage situations. We haven’t seen a lot of opportunities in merger arbitrage and distressed debt in an international context, so we haven’t been particularly active in those areas. The geographic mix of the fund is about 40% Asia Pacific, 50% Europe and about 10% cash. We like to maintain flexibility on the cash side, because it allows us to move quickly. We recently reduced our cash position on the dip in the market, but overall we are long-term investors and we are patient.
TWST: Is there anything else you’d add in terms of the criteria you focus on when selecting individual investments?
Mr. Sleeman: We focus a lot on cash flows and also the balance sheet. We try to break companies down to look at the sum of the parts as well, to see if there is a really good business that is being hidden by an underperforming business, and whether that can be addressed by the company. But we’d emphasize balance sheet and cash flow.
TWST: You have a bottom-up approach, but what is your macro view of the international markets at this time, and how do you incorporate that with the bottom-up look at individual stocks?
Mr. Sleeman: I’d start by saying every stock has to stand on its own merits in the portfolio. To that end, we do construct a portfolio from the bottom up, but we need to be mindful in every investment of the conditions in the market. European equities at the moment are bearing the brunt of investors’ worries about the sovereign debt crisis and the potential disappearance of the euro. As it stands currently with one currency, one monetary policy, but 17 different fiscal policies, the eurozone is at a critical juncture in its history. The question is whether the political will is there to move all the countries involved toward a closer budgetary and fiscal coordination, and do the voters understand the ramifications of going one way or the other?
One has to wonder whether it gets worse before it gets better. Perhaps it does. I expect more uncertainty with sporadic patch work to kick the can down the road before any final resolution. And in that context, I doubt we’ll see much if any economic growth. In fact, economic contraction wouldn’t surprise me at the moment.
If we switch over to Asia, which is the other major part of our portfolio, China is still a controlled economy with plenty of tools at its disposal. I’m not sure how people define hard versus soft landing, and China doesn’t need the same growth rate as it had in the past to ensure social harmony, so we don’t really think too much about a hard versus soft landing. But social harmony is what it’s going to be all about for the new administration. At the moment, they’re probably running a little bit below the economic growth rate that they want, but we’re seeing some initiatives at the moment to loosen the conditions. And I think that under the new administration at the end of the year, we’ll see even more initiatives, which would give us a path forward for the next couple of years; and that will be consistent with their five-year plan that they’ve already announced. But they do have a challenge going forward, and it’s a little bit different in empowering the consumer, which they’re focusing on at the moment — the “heroic savers,” as they say, or the consumer needs to get more economic returns for their saving. Interest rates offered by the banks have been regulated, and it’s driving disintermediation from the banking sector. That means that the cost of capital is rising, where in the past malinvestment has actually being driven by cheap capital. So deregulation of the system is happening faster than many expected, but this means control of the economy is diminished. So I’m not concerned immediately, but I’m closely watching how that develops. I guess what I’d say is, we’ve got uncertainty in Europe, and they’re constricted with what they can do to resolve those issues at the moment, while there is no clear political will. And in Asia, you’ve got a controlled economy in China, which at least for the time being, has the tools at their disposal.
TWST: Is the fund, due to any themes or trends, over- or underweight any particular sectors right now?
Mr. Sleeman: We’re index agnostic, so we don’t look at the world from a top-down perspective and pick where we’re going to be. We are aware of the index even though we don’t manage to it. We’re overweight financials, which might surprise. We’re also overweight consumables. We’re underweight energy, and we’re underweight materials.
I would say that from the underweight perspective, with oil prices having traded around the $120 level and certainly $100 priced into them, with the marginal dollar of production we think below $90, energy stocks haven’t been particularly attractive. However, after the recent underperformance of that sector, it’s starting to look more interesting to us.
How these stocks are categorized does matter. When I say we’re overweight consumer discretionary, it’s mainly media, hotel and leisure where we’ve been overweight. For example, on the media side, we’ve owned things like AUSTAR, which was an Australian pay TV company which was acquired by FOXTEL. We own another company called SinoMedia (0623.HK), which is one of our favorite names. SinoMedia is a stock that trades on six times earnings, but more than half of its market cap today is in cash, so it’s really trading on three times earnings ex- that cash holding. SinoMedia sells advertising space for the CCTV, the state-owned broadcasting companies, into the market.
And Chinese companies typically spend twice the percentage of sales of Western companies on advertising and promotion, because they’re trying to establish brand, which is quite interesting. So we like SinoMedia as a play on that. Another name that for whatever reason falls into the consumer discretionary bucket is called Seven Group (SVW.AX). It’s a holding company that has two assets, a media company in Australia, and the largest Caterpillar (CAT) dealership in Australia and China. So it’s actually an indirect play on the materials sector. We’ve taken profits in that name.
On the hotel and leisure side, we’ve been involved in a name called REXLot (0555.HK), which has the biggest footprint of lottery administration in China. The lottery revenues to the Chinese government are very important. REXLot has the license to distribute the machines that are used by the outlets.
They also distribute the scratchy cards that you and I are familiar with. And increasingly, they’re going into single-game betting. The NBA is huge in China, and these guys offer betting, which was previously carried out illegally, but China has made that legal. So they’re benefiting from that growth, as well as being a first-mover in mobile lotteries. It’s quite an interesting business with very solid cash flows, trading at six times earnings. We also own the Mandarin Oriental Hotel (M04.SI) chain, as well as a stake in the French hotel group Accor (AC.PA), and another name that fits within that business, Ladbrokes (LAD.L), the U.K. betting shops chain.
The other area, financials, is one that may surprise you, where we actually have generated a lot of our outperformance. When people think about financials, they tend to think of banks. We are less involved in the banking sector and much more involved in the insurance sector, specifically property and casualty insurance, which has far less leverage on their balance sheets than banks, and even less than life insurers. Let’s say a bank has a leverage of 20 to 40 times assets to equities and a life insurer might be 10 to one; a property and casualty insurer will be more like three or four to one. So we like the fact that we don’t have that asset leverage exposure, and we also like the fact that most of their earnings are generated from managing risk. In this uncertain world, we think that those guys will be paid better for risk as we move forward. And indeed, the pricing environment is starting to firm up. We focus very closely on who are the better underwriters, who has the ability to move their portfolio around, and who is positioned in the best property and casualty markets around the world.
Two of our favorite names are actually what one might consider to be European names, even though they’re global companies. Royal & Sun Alliance (RSA.L) is a U.K.-based property and casualty insurer with 9% dividend yield. So we’re paid to wait for the value to be realized by Mr. Market. They have businesses in Scandinavia, Canada and Latin America, which are all very interactive businesses. The U.K. business that they own is not a huge business for them and it’s not that attractive, but we know a lot of other similar businesses that would be very interested in owning their franchises in other jurisdictions that I’ve mentioned. The other one is Zurich Financial (ZURN.VX). Zurich Financial actually reports in U.S. dollars; it’s based in Switzerland. It has an 8% dividend yield, and what’s interesting about Zurich compared to some of the other property and casualty insurers around the world is the Farmers franchise, which they manage; they don’t own the balance sheet, so it’s basically a fee business, which allows them to generate much higher ROEs than their peers. It also generates better cash flow to sustain that dividend that I talked about.
We’ve been underweight banks, particularly in Europe. We have some Asian bank exposure. The financials have traded with a very high correlation, particularly the banks around the world, and so we’ve taken that opportunity to invest in some situations in Asia that have been brought down with Western financials. We’re waiting for those ideas to play out, and we’ve been very happy with our financials’ performance.
TWST: How nervous are you about Eurozone issues?
Mr. Sleeman: As I mentioned before, I think there are some significant structural issues that urgently need to be rectified in Europe. It’s not clear at this juncture how that’s going to be resolved. We expect continued volatility and uncertainty, and we actually think that’s going to create a lot of opportunity for us. At the moment, we can buy global companies that happen to be domiciled in Europe at a much steeper discount to their U.S. peers, which is a very attractive opportunity for investors. These are global franchises whose earnings are as diversified as their U.S. peers might be, it just happens that their headquarters might be in France or the Netherlands. I do believe that investing in a company domiciled in Europe is very different from investing in European equities. I’m thinking of health care companies like Novartis (NVS) and Roche (RO.SW), or oil stocks, such as BP (BP) and Royal Dutch Shell (RDS-A). We can buy those companies at much steeper discounts than their U.S. peers. The European cyclically adjusted p/e is trading at an all-time low at the moment. This being said, we’re very careful about which stock we invest in.
TWST: You said earlier the portfolio is about 40% Asia Pacific and 50% Europe. Do you stay out of the Americas?
Mr. Sleeman: We are primarily a developed market investor. Now, in an Asian context it’s pretty hard to say that you’re a developed market investor, because 60%-plus of the Hong Kong market cap is really composed of Chinese companies. We don’t actively look for developing markets equity exposure. Traditionally, those stocks have traded at a higher multiple than we would be willing to pay. So we are primarily Asian and European. And on the European side, we tend to be Western European. We can get the Russian and Eastern European exposures through Western European companies if we want, with better corporate governance and better liquidity. Similarly, in the Asia Pacific region, some of our biggest and most successful investments have been Hong Kong or Singapore, domiciled conglomerates that have good oversight and expertise in the ASEAN region.
To that end, First Pacific (0142.HK), which we own, is a Hong Kong domiciled conglomerate with great cash flowing businesses in the Philippines and in Indonesia. And we can buy those assets at a conglomerate discount, at a discount to what we would have to pay for the individual sum of the parts. The same with the Jardines. Jardine Matheson (J36.SI) and Jardine Strategic (J37.SI) have been invested in the ASEAN region since the 1800s, and have connections, which arguably are second to none in those regions. And we can buy the sum of the parts of the individual investments at a 40% discount. So when we look at each individual business, it may be domiciled in one spot but have exposure in others, and we pay a lot of attention to corporate governance and oversight, and the expertise that management has and the tenure of the management and the company in those individual markets.
TWST: You mentioned that you’re index-agnostic. What do you use as a benchmark for the fund, and what is the fund’s performance record?
Mr. Sleeman: The benchmark for the fund is the MSCI EAFE in local currency, because for the most part we hedge out the currency exposure. Let me add that the Fund’s performance versus its Lipper peers puts it in the top decile for the quarter, the year-to-date, the year, and the three-year period, which we’ve just reached.
TWST: If an investor were to ask you, “Why should I consider this fund as part of my overall investment portfolio,” what would you tell them?
Mr. Sleeman: Philippe Brugere-Trelat, my co-PM, and I have over 50 years’ experience in international financial markets. The fund has the ability to buy global franchises that happen to be domiciled in Europe at all-time cyclically adjusted low p/e. We can buy emerging businesses in Asia at very low multiples from time to time in what can be a bit of a schizophrenic market, but we buy businesses that often are not well understood. We’re an all-cap fund, so we can go anywhere. We can be nimble. But I would say, in the end, it’s about our cultural approach to risk. In that way, in any investment, we think as much about the downside risk as the upside return, and we think of our investments as an owner would think about the investment. And really, the Mutual International Fund gives you that sort of exposure outside of the U.S., where most investors feel less familiar.
TWST: Looking toward the second half of this year and into 2013, what is your overall outlook?
Mr. Sleeman: We expect more volatility and more opportunities. I would point out that investors gave up on Asia back during their crisis in 1997. Europe could present a similar opportunity. We think it presents a similar opportunity over the next 12 to 18 months. And so, when one looks at what sort of performance Asia had coming out of their crisis, we think Europe will present that opportunity. On the Asian side, it’s a little bit of a different story. Asia ex- Japan doesn’t have the same fiscal issues that we face in the U.S. and Europe and Japan, but fewer long-term value investors in that part of the world are prepared to be patient. So we think there is going to be a lot of opportunity in Asia for investors who look at the fundamentals of the business and focus on value, and there are not many of us who think like that.
TWST: Is there anything you would like to add?
Mr. Sleeman: The thing I’d say is that we run a diversified portfolio, we monitor things closely, we understand, we measure and take advantage of risk. I’d like to emphasize that there is a culture of risk management that’s ingrained in every investment that we make.
TWST: Thank you. (MN)
Andrew Sleeman, CFA
Portfolio Manager & Research Analyst
Franklin Mutual Advisers, LLC
101 John F. Kennedy Pkwy.
Short Hills, NJ 07078